Exponent Inc Q2 FY2023 Earnings Call

Good day. And welcome to the Exponent’s Second Quarter Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Joni Konstantelos with Investor Relations. Please go ahead.

Thank you. Good afternoon, ladies and gentlemen. Thank you for joining us on Exponent’s second quarter 2023 financial results conference call. Please note that this call will simultaneously webcast on the Investor Relations section of the company’s corporate website at www.exponent.com/investors. This conference call is the property of Exponent and any taping or other reproduction is expressly prohibited without prior written consent. Joining me on the call today are Dr. Catherine Corrigan, President and Chief Executive Officer; and Rich Schlenker, Executive Vice President and Chief Financial Officer. Before we start, I would like to remind you that the following discussion contains forward-looking statements, including, but not limited to, Exponent’s market opportunities and future financial results that involve risks and uncertainties that may cause actual results to differ materially from those discussed here. Additional information that could cause actual results to differ from forward-looking statements can be found in Exponent’s periodic SEC filings, including those factors discussed under the caption Risk Factor in Exponent’s most recent Form 10-Q. The forward-looking statements and risks in this conference call are based on current expectations as of today, and Exponent assumes no obligation to update or revise them, whether as a result of new developments or otherwise. And now I will turn the call over to Dr. Catherine Corrigan, Chief Executive Officer. Catherine?

Thank you, Joni, and thank you everyone for joining us today. I will start off by reviewing our second quarter 2023 business performance. Rich will then provide a more detailed review of our financial results and outlook, and we will then open the call for questions. We delivered solid second quarter results, growing net revenues by 10% and expanding earnings per diluted share. We continue to demonstrate the strength of our diverse and ever-evolving services portfolio, which anticipates and adapts to our clients' critical needs throughout their product life cycles. Growth in the quarter was driven by robust demand for our reactive offerings. The proactive side saw increased demand in the chemicals and life sciences sectors, offset by some moderation in the electronics sector. Overall, our strategic mix of capabilities across industries and the product life cycle performed well despite specific headwinds that I will discuss in a moment. Turning to our engagements in more detail. Within our reactive services, we saw strong increased demand for our disputes and litigation-related work, with particular strength in the transportation, construction, and consumer product sectors. On the automotive side, we are fielding more and more questions about the design and performance of advanced driver assistance and battery systems in accident scenarios, as these technologies become more complex and more prevalent in the fleet and the decisions made by artificial intelligence algorithms are challenged. We also saw increased product safety and recall-related engagements as clients leveraged our expert insights to understand the root cause of issues with their products. The proactive side benefited from increased demand in the chemicals and life science sectors driven in large part by regulatory engagements. This was offset by some moderation in the electronics industry, associated with the timing of client product releases coupled with the disruption caused by the actions the industry has taken to reduce staff. These factors impacted data gathering activities and human subject research, as well as product development consulting, as products moved through their life cycles out of the development stage and into the refinement stage. While we expect these trends within electronics to persist over the next few quarters, we are optimistic about the longer-term opportunities in this sector. We are well positioned given the increasing role of artificial intelligence in product innovation and performance, with our capabilities in curating data to drive AI algorithms, as well as our experience analyzing the physical consequences of AI-driven decisions. Our diverse portfolio of proactive offerings positions us well to capitalize on the complexities associated with next-generation designs and increasing expectations around safety, health, and the environment. Improved retention, as well as our accelerated recruiting efforts over the last year drove a 15% increase in headcount year-over-year, which reflects the strength of our employee value proposition. While these investments in our talent are critical for our future growth, we remain diligently focused on aligning our resources with the growth of the business and future opportunities. Rich will share some additional color on our expected headcount growth in a few moments. Turning to our segments. Exponent’s engineering and other scientific segment represented 83% of our net revenues in the second quarter, increasing 10% in the second quarter and 11% in the first half compared to the prior year. Growth in the quarter was driven by strong demand for Exponent services across the transportation and construction sectors. Exponent’s environmental and health segment represented 17% of the company’s net revenues in the second quarter. Net revenues in this segment increased 10% in the quarter and 4% in the first half compared to the prior year. Growth was driven by regulatory consulting around the impacts of chemicals on human health and the environment, as well as activity in the life sciences sector. As we move into the back half of the year, we remain focused on strengthening our client relationships, managing resources in line with the growth of the business and meeting the dynamic needs of our clients. Overall, I am pleased to see the power of our diverse portfolio delivering solid growth through economic cycles as we address our clients' most complex challenges. I will now turn the call over to Rich to provide more detail on our second quarter results, as well as discuss our outlook for the third quarter and the full year 2023.

Thank you, Catherine, and good afternoon, everyone. Let me start by saying all comparisons will be on a year-over-year basis unless otherwise noted. For the second quarter of 2023, total revenues increased 7.6% to $140.2 million and revenue before reimbursements or net revenues, as I will refer to them from here on, increased 9.7% to $129.7 million as compared to the same period of 2022. Net income for the second quarter was $25.7 million or $0.50 per diluted share, as compared to $25.8 million or $0.49 per diluted share in the prior year period. The realized tax benefit associated with accounting for share-based awards was immaterial in the second quarters of 2023 and 2022. Exponent’s consolidated tax rate was 29% in the second quarter, as compared to 27.3% for the same period of 2022. EBITDA for the second quarter decreased less than 1% to $36.8 million, producing a margin of 28.4% of net revenues, as compared to $37.1 million, which was a margin of 31.4% in the same period of 2022. The year-over-year step down in margins was anticipated as expenses normalize post-pandemic. Billable hours in the second quarter were approximately 388,000, an increase of 4.4% year-over-year. The average technical full-time equivalent employees in the second quarter were 1,077, which is an increase of 15% as compared to one year ago. This exceeded our expectations as recruiting has been very successful and retention has improved. Utilization in the quarter was 69%, down from 77% in the same period of 2022. While we expected utilization to decline from the elevated level it was in the second quarter of last year, our higher than anticipated headcount resulted in lower utilization in the quarter. As Catherine mentioned, we are diligently focused on strategically balancing our resources with the growth of the business and our pursuit of future opportunities. The realized rate increase was approximately 5.3% for the second quarter as compared to the same period a year ago. In the second quarter, after adjusting for gains and losses in deferred compensation expense, compensation expense increased 12.6%. Included in total compensation expense is a deferred compensation gain of $4.1 million, as compared to a loss of $11.3 million in the same period of 2022. This is a $15.4 million swing. As a reminder, gains and losses in deferred compensation are offset in miscellaneous income and have no impact on the bottom line. Stock-based compensation expense in the second quarter was $5.2 million, as compared to $4.6 million in the prior year period. Other operating expenses in the second quarter were up 17.7% to $10.3 million, driven primarily by increased employee activity at our offices. Included in other operating expenses is depreciation and amortization expense of $2.2 million for the second quarter. General and administrative expenses were up 15.6% to $6.6 million for the second quarter. The increase in G&A expenses was primarily due to increased travel as employees return to in-person engagement with clients and professional development. Interest income increased to $1.6 million for the second quarter, driven by an increase in interest rates. Miscellaneous income, excluding the deferred compensation gain, was approximately $700,000 in the second quarter. During the quarter, capital expenditures were $5.4 million and we distributed $13.2 million to shareholders through dividend payments. We ended the second quarter with $148.2 million in cash and cash equivalents. Turning to our outlook. Our full year 2023 outlook is unchanged. For the third quarter 2023, as compared to one year prior, we expect revenues before reimbursements to grow in the high single to low double digits and EBITDA margin to be 27.5% to 28.5% of revenues before reimbursements. For the full year 2023, as compared to one year prior, we are maintaining our guidance and expect revenues before reimbursements to grow in the high single to low double digits and EBITDA margin to be 28% to 28.5% of revenues before reimbursements. As mentioned, we remain focused on strategically aligning our headcount with the growth of the business. These actions include reducing hiring and increasing performance management. As a result, in each of the next two quarters, we expect technical full-time equivalent employees to decline sequentially 2% to 3%. Over the next quarter or two, our hiring will be surgical in nature to address areas of high utilization and strategic growth. We have also increased performance management, which will increase turnover. Performance management is ongoing in our firm as we evaluate each employee’s career trajectory towards determining if they are on a path to principal or if their career skills are better aligned with a career in industry, government, or academia. Performance management tends to be less when resources are constrained and turnover is high such as in 2021 and 2022. We expect utilization in the third quarter to be 68% to 70%, as compared to 73% in the same quarter last year. Utilization in the third quarter will continue to be tempered by increased headcount, as well as seasonally higher vacation and holiday time during the summer months. Our expectations for full year utilization is 69% to 70%, as compared to 73.8% in 2022. We still believe our long-term target of sustained mid-70s utilization is achievable as we continue to strategically manage headcount and balance utilization based on market demand. We expect the 2023 year-over-year realized rate increase to be 4.75% to 5.5%. For the remaining quarters, we expect stock-based compensation to be $4.8 million to $5.2 million. For the full year 2023, we expect stock-based compensation to be $22 million to $22.8 million. For the third quarter, we expect other operating expenses to be $10.7 million to $11 million. For the full year, we expect other operating expenses to be $41.7 million to $42 million, as in-office activities continue to pick up. G&A expenses are increasing as post-pandemic travel increases for business and professional development. For the third quarter of 2023, we expect G&A expenses to be $7.3 million to $7.7 million. For the full year, we expect G&A expenses to be $26.7 million to $27.2 million. We expect interest income to be approximately $1.8 million per quarter for the remaining quarters of 2023. In addition, we expect miscellaneous income to be approximately $750,000 per quarter. For the remainder of 2023, we do not anticipate any additional tax benefit associated with share-based awards. So the year-over-year tax benefit associated with share-based awards will be $2.4 million, less than it was in 2022, which is a $0.05 per diluted share impact to EPS. For 2023, we expect our tax rate, exclusive of the tax benefit for share-based awards to be approximately 28.5%, as compared to 27.0% in 2022. For the third quarter of 2023, we expect our tax rate to be approximately 29%, as compared to 27% in the same quarter a year ago. For the full year 2023, the tax rate inclusive of the tax benefit for share-based awards is expected to be 26.1%, as compared to 22.6% in 2022. In closing, our second-quarter results continue to underscore the strength of our business model and financial position. As we look to the back half of the year, we remain positioned to continue our profitable growth. I will now turn the call back to Catherine for closing remarks.

Thank you, Rich. Exponent continues to advance science and engineering to empower our clients with solutions to their most critical challenges. We are uniquely positioned to advise them as they navigate the complexity of society’s increasing expectations around safety, health, and the environment. Supported by the strength of our world-class team and our ever-evolving services portfolio, we remain confident in our ability to drive profitability and shareholder value over the long term. Operator, we are now ready for questions.

Our first question comes from Josh Chan from UBS. Please go ahead.

Hi. Good afternoon, Catherine and Rich. Thanks for taking the questions.

Hi, Josh.

Hi. I have a two-part question regarding demand. First, on the reactive side, it seems like that business is growing at a rate above the norm, and Catherine mentioned some factors driving this. Do you believe that this above-normal growth is sustainable moving forward? Secondly, on the proactive side, it's difficult to determine if that business may have slowed a bit in Q2. It sounds like it might have, but could you give us an estimate of how widespread the fluctuations have been? That would be really helpful.

Thank you, Josh. Firstly, regarding the reactive side, we are observing that the increasing complexity of products is a significant factor driving our reactive work. I mentioned advanced driver assistance systems as an example. The incorporation of artificial intelligence into various products is becoming more prevalent, whether it's automated vehicles, wearable health devices, or AR, VR, and mixed reality technologies used for employee training and more. We are positioning ourselves to address these complexities through our research and by developing our teams. We believe this trend is not a temporary phase in our growth but rather that our portfolio has strong market drivers. Additionally, there are international expansion opportunities related to disputes and the evolving EU frameworks around product recalls. We are quite optimistic about the growth potential in this part of our portfolio. On the proactive side, we acknowledged some moderation in performance. We do have strengths in several areas, particularly with growth in regulatory aspects and agricultural chemicals, as well as pharmaceuticals in life sciences. However, the electronics industry is experiencing some moderation due to various factors, including disruptions from layoffs that have affected workflow. Companies are currently restructuring and stabilizing, which can take a few quarters. We are starting to see signs of stabilization and a return of workflow. Some of our activities, such as data collection and human subject work, are affected in the short term by the product life cycle and where our clients are in that cycle, seeing surges during development and product launches, followed by refinement phases. Clients are also managing their budgets more carefully, which is understandable. We are anticipating that this trend will continue over the next couple of quarters. We noticed it in Q2 and expect it to persist in the coming quarters. However, we remain positive about the long-term focus on the quality of data used for AI training and decision-making, as well as the competitive landscape in that sector. This gives us confidence about the long-term potential of our offerings, and we will continue to adapt them to seize what we believe is a valuable opportunity.

Thanks, Catherine. That’s really good color there. I appreciate that. And then, I guess, like, my second question on margins this quarter. Just conceptually, it seems like utilization ticked down from Q1 going to Q2, but somehow you were able to deliver stronger margins this quarter. So could you talk about what’s driving that kind of sequential margin improvement even though you didn’t have the utilization help there?

Yes. The improvement in margins is primarily due to the compensation expenses. We typically incur higher costs for stock-based compensation in the first quarter, which amounted to about $7.5 million, compared to around $5.2 million in the second quarter. This difference is related to the timing of our grant issuances and the accounting practices associated with them. Additionally, most of our new hires have been at entry-level positions. When you consider the bill rates in relation to changes in compensation, this also contributes to the margin enhancement.

Okay. Thanks. Thanks for that, Rich. And then, I guess, lastly, how are you seeing the impacts between revenue per billable hour growth and wage inflation? I think you gave some color on what you expect for revenue per billable hour for the year, but just wondering how you are thinking about that balance? Thank you.

On a per consultant basis, we have observed an increase in our rates, even though we implemented significant wage increases for our staff starting April 1, which were in effect during the second quarter. This led to a blended increase in rates that was essentially flat to about 1% due to the mix of employees we had. The combination of these incoming employees resulted in a slight wage increase, alongside a billing rate increase of approximately 5.3%.

Thanks. Thank you for that, and thanks for your time.

The next question comes from Tobey Sommer from Truist. Please go ahead.

Thanks. I wanted to follow-up on the sort of the broad headcount in revenue and expense growth. Are you comfortable with this amount of headcount growth and the near-term demand picture, so that you can continue to maintain a bottom-line growth rate sort of in excess of your revenue growth?

Thank you, Tobey. We are aiming to slow down our headcount growth to ensure it aligns with both short-term and long-term demand and opportunities. There are two main components to this strategy. First, we are focusing on recruitment, particularly in the areas of the business that are experiencing strong growth. We want to strategically recruit to ensure we can meet market demand even with limited resources. For instance, we aim to recruit in the advanced driver assistance sector to capitalize on that opportunity. The second component involves managing our headcount through performance management, which Rich touched on. We are always in search of top talent, and we have a rigorous acquisition process that sets them on a path for growth from day one. However, progressing to a principal consultant role at Exponent is challenging and not suitable for everyone. Some employees may find better opportunities elsewhere, and our performance management process helps guide them in that regard. As Rich indicated, we plan to sequentially reduce headcount by 2% to 3% per quarter over the next few quarters to restore balance between these factors.

I appreciate that. Could you speak to artificial intelligence and all its forms, and what you think it means internally for your company, how you engage with your customers, and ultimately, how it may impact demand for your services?

We are actively involved across the entire life cycle of artificial intelligence algorithms. It begins with the data used to create them, particularly the training data sets. Ensuring that these data sets have the right diversity and are properly curated is a crucial first step. We discuss this with clients, as well as the ontologies involved and the necessary data cleaning, since real-world data can be messy. Exponent has a strong track record of leveraging real-world data to extract insights due to our subject matter expertise. When speaking with clients, we emphasize how this is where AI intersects with the laws of physics. Exponent has long applied its understanding of physics to evaluate the consequences of various decisions, whether related to product design or asset management for utilities. This combination of using data to drive algorithms, applying physics to make them tangible, and producing actionable decisions creates opportunities at every stage of the process. Our extensive experience throughout the product life cycle provides a solid foundation, and our ability to connect the laws of physics with human behavior allows us to offer significant value across different industries, positioning us well for growth.

And so, as Catherine had said earlier, where we have already done this work and are gaining top recognition in the marketplace by key players over the last even year or two is in the automated vehicle or really actually in the ADAS systems, the subsystems within those vehicles, you don’t need to be fully autonomous to have a braking decision or a steering decision or those other things. It’s been in the risk models and decision models that utilities out here on the West Coast are doing to make a decision about the resiliency of their system or particular lines in making a decision at what winds speed or what environment to make a decision and do that. And to have that happen real time as the weather is changing, as those inputs are coming in and have that model built in an engineering basis, so that you can rely upon those decisions you are doing or over into what we are seeing our clients develop in their health applications in wearable technologies where they want their customers to ultimately be able to rely upon the feedback coming from that wearable device to understand when they really need to seek medical attention and do such. And then, finally, as we are moving into the AR and VR area, clients who want to have a true real-world experience and deal with the safety and reliability and quality of those experiences are wanting to make sure that they are utilizing curated data to have those experiences. So those are examples of what we have already done. I think the future is quite significant for us going forward.

Thank you. If I could sneak a last one in. Could you update us on the large contract exposure or opportunity should there not be kind of classically defined large contracts? And my question comes in the context of having observed all the news around legacy telco cables with lead, which at least bound in stock markets are assuming represents pretty significant liabilities and exposures for those firms?

We haven't had a single project recently that constitutes 4% to 5% of our revenues. We have had various collections from different areas, particularly in data collection, that come close to that percentage, but not a single project. Historically, a few projects that reached that level of revenue were related to health exposures and environmental contaminants, such as our work for BP on the Deepwater Horizon incident back in the mid-2010s. While we haven't undertaken any projects of this magnitude lately, we've conducted extensive work over the past twenty years regarding asbestos, talc, and other exposures. We have leading experts in environmental and health exposure consequences, and we'll see how this industry issue develops.

Thank you.

This concludes our question-and-answer session. The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.